An Evaluation Of Emerging Markets

The world has emerged faster than our understanding of world markets has emerged. Measured by purchasing power parity, China has the world's second largest gross domestic product (GDP). More than three-quarters of the world's electricity is consumed outside of the United States. The world's largest producer and distributor of natural gas is a Russian concern called Gazprom. Global mergers and acquisitions in many industry sectors are characterized by enterprises in "emerging" markets becoming global leaders through serial acquisitions of competitors in other emerging and developed countries alike. TUTORIAL: Exchange-Traded Funds

With the astounding growth that is happening in emerging markets, it is surprising that, as an asset class, they play a relatively small role in most U.S. investment portfolios - institutional and retail alike. A common rule of thumb is to cap emerging market exposure at 5% of a diversified portfolio's risk-based assets. Unfortunately, this benchmark is arbitrarily derived and, as a result, it may be outdated. To understand this, we need to better understand what emerging markets really are, how their risk-return characteristics have evolved and where they belong in modern investment portfolios.

The Evolution of Global MarketsSince the end of WWII, the international capital markets have gone through two distinct phases of evolution and are now in the early stages of a third phase.

The first phase could be called the "age of globalism." This was an era of man-made creations to reconstruct the world after the destruction wrought by two world wars and a global depression. At the 1944 conference in Bretton Woods, New Hampshire, the International Monetary Fund (IMF) was established along with the Bretton Woods Agreement and the attendant infrastructure of international finance, facilitating 25 years of shared growth and prosperity.

The second phase, the "age of globalization," came in the form of a disruptive tsunami unleashed with the marriage of Moore's law to market liberalization. The geometrically explosive power of modern computing met the crumbling of the Bretton Woods fixed exchange rate system in the early 1970s, the rise of the eurobond market and the pioneering theories of derivative securities to beget a perfect storm of new financial opportunities unconstrained by national borders and restrictive policies.

It was during this period that the phrase "emerging markets" gained popularity. Of course, there have always been emerging markets. The U.S. was once an emerging market itself, back in the 19th century, when England, France and other European countries were the dominant powers. The early post-war period saw the emergence of Japan from total devastation to a vibrant, high growth economy - the prototype the modern emerging market. (For more insight, seeWhat Is An Emerging Market Economy?)

The globalization tsunami washed over places where markets had long been absent. In communist China, doctrine from Mao Zedong's "Little Red Book," a book of quotations from Zedong that was distributed among communist party members, gave way to a new more capitalist maxim that, "To Get Rich is Glorious." In Eastern Europe, security walls crumbled and securities exchanges lit up for business. Portfolio and direct investment capital from the developed markets of North America, Europe and an "emerged" Japan raced around the globe in search of the next can't-miss opportunity. Much of this capital, particularly the portfolio money, was not in it for the long-term but ready to repatriate to the home country when times got tough, such as in Thailand in 1997 and Russia in 1998.

Dawn of Global CapitalizationThis brings us to the third phase of global market evolution, the "age of global capitalization." What's different about this phase is that it is not about a bipolar world with developed markets on one end, emerging markets on the other and unidirectional capital flows from rich to poor. It's about countries and regions mobilizing their own capital sources from increasingly wealthy business and consumer populations. In other words, capital locations are becoming more closely correlated with manufacturing, service and consumer locations. Consider the following: South Korea and Israel are part of the MSCI Emerging Markets Index, but have higher real per capita GDP than Greece, which is part of the MSCI EAFE

Around the world, new capital markets reflect both standards of global best practices and local flavor. Poland's pension investment system, the tech-heavy Tel Aviv Stock Exchange and the Ukrainian corporate bond market are all distinct local markets with rapidly evolving legal, regulatory and procedural standards. Increasingly, what happens on these markets is not driven primarily by flavor-of-the-day decisions in London or New York, but rather the strategic actions of large companies in Russia, Brazil or China (for example) on the world stage.

Risk and ReturnIf the lines between developed and emerging markets are blurring, we would expect to see evidence of this in risk-return profiles. Simply put, the traditional rationale for investing in emerging markets has been to dedicate a portion of a portfolio to assuming increased risk in pursuit of higher potential returns. One implication of global capitalization is that the risk-return boundaries would become less sharply delineated. The following chart provides an illustration of this. It measures the returns of selected markets on an annual average basis over a five-year period and the average risk, as measured by standard deviation, for the same period.

Figure 1

Source: Zephyr & Associates LLC StyleAdvisor

Figure 1 shows a reasonably predictable progression from low risk/low return to high risk/high return with a few cyclical outliers. The interesting thing is the blurring of boundaries, with emerging markets Malaysia and Brazil, book-ending the lower risk and higher risk corners of the quadrant, with various developed and emerging markets occupying positions in between. These positions are certainly not static, but they suggest a much more nuanced reality than the traditional, simplistic risk bifurcation of developed and emerging international markets. (To read more about international investing, see Getting Into International Investing.)

The Bottom LineThe point, ultimately, is not to dramatically increase emerging markets from 5 to 50% of your portfolio. As Figure 1 suggests, there are plenty of high volatility markets out there that are not suitable for everyone's risk tolerances or investment objectives. The point is that the volatility is not captured in a simple developed-versus-emerging paradigm and that true risk-efficient returns are more likely to come from a strategy based on a more sophisticated understanding of these markets and the opportunities they present.

Part of what makes investing a challenge is that we have to avoid getting caught in a mind-set that doesn't keep pace with the evolving realities of the capital markets. Markets sometimes behave like geological tectonic plates - they can creep along for years undisturbed and then suddenly collide and create tremendous disruptions. These tectonic events affect a large amount of global wealth. Understanding how to make sense of them is a critical factor to achieving investment success.